The economics of growth has shown that countries not only grow by deploying higher
levels of inputs to production, but also by better allocating whatever resources are at their
disposal and by introducing productivity-enhancing innovations. We proffer arguments
as to why and how entrepreneurship as well institutions of liberty (i.e., economic
freedom, including the rule of law, easy regulations, low taxes and limited government
interference in the economy) positively impact total factor productivity (TFP): These
institutions allow entrepreneurial experimentation with the combination of factors to take
place at low transaction costs. We test these ideas on a unique panel data set derived
from Compendia, World Bank data and the Fraser Institute’s economic freedom data. We
find that while entrepreneurship positively impacts TFP, the marginal contribution of
entrepreneurship to TFP is strongest in economies with substantial government activity.

While much attention has been devoted to analyzing how the institutional framework and entrepreneurship impact growth, how economic policy and institutional design affect entrepreneurship appears to be much less analyzed. We try to explain cross-country differences in the level of entrepreneurship by differences in economic policy and institutional design. Specifically, we use the measures of economic freedom to ask which elements of economic policy making and the institutional framework that are responsible for the supply of entrepreneurship (our data on entrepreneurship are derived from the Global Entrepreneurship Monitor). The combination of these two datasets is unique in the literature. We find that the size of government is negatively correlated with entrepreneurial activity but that sound money is positively correlated with entrepreneurial activity. Other measures of economic freedom are not significantly correlated with entrepreneurship.
JEL CODE: M13, O31, O50
KEYWORDS: Economic freedom, entrepreneurship, cross-country variation.